Transfer Pricing Demystified

Posted in Finance Articles, Total Reads: 4761
, Published on 17 July 2011

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Transfer Pricing is simply the act of pricing of goods and services or intangibles when the same is sold to between divisions of a company or between companies in the same group. There can be either Market-based, i.e. equivalent to what is being charged in the outside market for similar goods, or it can be non-market based. The value at which goods and services are transferred from one unit to another unit is called transfer price.

When each decentralized unit of an organization is deemed as a profit centre and transfer of goods and services amongst the independent profit centers take place, the problem of intra-company transfer pricing arises. For example two or more profit centers are jointly responsible for product development, manufacturing and marketing; each should share in the revenue generated when the product is finally sold.

Consider there are two divisions in the company, division 1 manufactures crucial component for the final product. Division 1 is called the upstream division. Each unit of crucial component is required to manufacture final product. There is no external market for the crucial component produced by upstream division. Division 2 called the downstream division completes the assembling and manufacturing process and distributes the final product. The integrated firm faces two questions. How much of the final product should it manufacture? At what price it should internally value crucial component produced by upstream division. The answers to both of these questions will maximize the firm’s profits. Coordinating these two outcomes is “JOB #1” for transfer pricing.

We want both the divisions to be efficient. Division 2 (downstream division) faces the discipline of market demand for the final product. But Division 1 (upstream) has no external market discipline. How do we create appropriate incentives for the upstream division? That is “JOB #2” for transfer pricing.

It is a three-country, three-division transfer-pricing problem with three alternative transfer-pricing methods for ABC Computer Inc. Summary data in U.S. dollars are:

China Plant

Variable costs: 1,000 Yuan ÷ 8 Yuan per $ = $125 per subunit

Fixed costs: 1,800 Yuan ÷ 8 Yuan per $ = $225 per subunit

South Korea Plant

Variable costs: 360,000 Won ÷ 1,200 Won per $ = $300 per unit

Fixed costs: 480,000 Won ÷ 1,200 Won per $ = $400 per unit

U.S. Plant

Variable costs: = $100 per unit

Fixed costs:= $200 per unit

Market prices for private-label sale alternatives:

China Plant: 3,600 Yuan ÷ 8 Yuan per $ = $450 per subunit

South Korea Plant: 1,560,000 Won ÷ 1,200 Won per $ = $1,300 per unit

US Plant: $3200 per unit

The transfer prices under each method are:

a. Market price

• China to South Korea = $450 per subunit

• South Korea to U.S. Plant = $1,300 per unit

b. 200% of full costs

• China to South Korea

2.0 x ($125 + $225) = $700 per subunit

• South Korea to U.S. Plant

2.0 x ($700 + $300 + $400) = $2,800 per unit

c. 300% of variable costs

• China to South Korea

3.0 x $125 = $375 per subunit

• South Korea to U.S. Plant

3.0 x ($375 + $300) = $2,025 per unit.

Assuming tax in the countries as follows:

China: 40%

South Korea: 20%

US: 30%

2. Division Net Income:

ABC Computer Inc will maximize its net income by using the 200% of full costs, transfer-pricing method. This is because the 200% of full cost method sources most income in the countries with the lower income tax rates.

The objective is to maximize the profit of the company by optimizing the transfer price among the divisions by looking variables like fixed price, variable price, tax structure within a particular country etc. Hope the above article is able to make you understand basics of transfer pricing.